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Trade of the Week - Iron Condor (3/29/2010)

I'm entering another iron condor trade this week. I currently have the remains of one I put on from about a month ago. This one is a little farther out in time, which allows me to get a better spread between short strikes and also collect a little more premium.

iron condor trade on the SPY

Sell May SPY 122/120/113/111 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.43)
2. Exit each spread if I can do so for 20% of the initial credit ($.21)
3. Exit if within 4-7 days of expiration
Credit $1.07

The spreads on each side are $2 wide with the spread between the short strikes of $7. That represents a $70 range of movement on the S&P 500 index (SPX), which is about the total range of movement the SPX made in the month of March.

Why this strategy?

It looks like the recent run up is starting to get a little bit tired and may head into a period of range bound trading. We could see more attempts to push up through the highs of $118 and maybe even up to $120.

Given the momentum and strength of this latest bullish move, I wouldn't be surprised to see a stronger sell-off, maybe all the way down to the 30 day MA. With this kind of potential movement, the logical choice is an iron condor.

I currently have the remainder of an iron condor on the SPY that I put on earlier this month but that trade will be completed one way or the other by April expiration. Since I'm looking out into May, I decided to go with another trade on the same underlying.

Choosing the right strike prices

I started out briefly looking at the April strikes, but we're now under 20 days until expiration and that doesn't leave enough room for movement or yield enough credit to offset the risk.

Next, I looked at may and started looking at strikes having a probability of expiring ITM of around 30-35. I chose the short 113 put and short 120 call because they were both right in the middle of that range.

iron condor strike selection

As I usually do, I went with a $2 wide spread. Why? Because it gives me a nice balance between ROI and number of contracts required to create the position.

Risk/Reward analysis

This trade will yield about $1.07 in credit, leaving about $.93 in risk. Let's take a quick look at a couple of different things from the analysis tools of the Thinkorswim platform.

First, the risk graph shows that our probability of expiring between the two break even points by May expiration is 42%. That doesn't sound too great does it?

iron condor risk graph

That's the reason I don't hold the trade all the way to expiration. The reward is pretty good but the probability isn't. I try to balance that off by closing a little earlier and settling for less of the profit.

Another cool perspective I just learned about by attending an Option Planet workshop was using the price slices to determine potential changes in the greeks with a move up or down in the SPY.

iron condor risk analysis

This tells me that I have a little more risk to the up side than to the downside. Notice my resulting delta if the SPY moves up $5. Part of that is due to the inherent skew that's already in place on this trade. It tells me that the trade will add a little more negative delta to the position and will pose more risk if another bullish breakout occurs.

Position sizing

With this trade, I don't have any early exits in my rules to limit loss. Because of the credit I receive, I'm willing to risk the remaining part of the spread to just let the trade run its course. That remaining portion is $.93.

My standard risk per trade is 2% of my portfolio, which right now is about $392. That means I can take 4 contracts on this trade and still remain within my risk tolerance. However... one thing I've discovered in some of my iron condor trades gone bad is that it is important to count the cost I pay to buy back the spread on the side that works out. In this trade, I'm planning to buy back the individual spreads if I can do so for $.21 (20% of the initial credit). That means I could be risking $1.14 per contract. If I sold 4 contracts, that means my risk is $456, which is more than I'm willing to risk.

I this case, I'm going to go with 3 contracts because I want to be free to let this trade run its course without being worried about how much it moves against me.

Exit plan

With my iron condor strategy, my exit rules are pretty simple and easy to implement.

I will exit under the following conditions.

  1. I will exit if I can lock in 60% of the initial credit, which means I will pay $.43 to buy the entire spread back.
  2. I will exit if I can buy back each individual spread for 20% of the initial credit, which means I'll pay $.21 for each side.
  3. I will exit when approximately 4-5 days of expiration

As always, if I can set these rules up to be executed automatically, then I'd prefer to do so. It makes sure I follow my rules and it means I don't have to be glued to my trading platform all day. In this case, a simple good 'till cancelled limit order for each side of the iron condor can be implemented. Most trading platforms support this kind of order.

Portfolio Impact

Theoretically, an iron condor is a neutral trade. However, it rarely is. In the case of this spread, we saw in the analysis section that this trade already had a slightly bearish skew to it.

iron condor portfolio impact

As a result, this trade leaves the overall portfolio more neutral than before but still slightly bullish as indicated by the positive position delta value. The additional theta means that even though the market may go up, down, or sideways over the next 20-40 days, I'll continue to make money on the position simply by having time pass.

Update 4/12/2010

Just over a week into this trade, the SPY is pushing up against the upper spread of this iron condor. After another strong week of buying, you have to wonder when the buying will stop.

Unfortunately, there is still too much time left in the put spread so we won't be able to close it out just yet. What are some trade management techniques?

  1. We could do nothing. After all, the trade was position sized to let the trade go to expiration facing the maximum loss.
  2. We could buy a call calendar spread somewhere above the short call strike. This allows us to pick up some additional credit if the SPY ends up near the short strike on or near expiration.
  3. We could close one or more of the call spreads, which removes some of the up side risk
  4. We could buy back one or more of the short calls to create what's known as a back spread. The effect is that we'd be left with one or more long calls

This is by no means an exhaustive list. There are any number of adjustments that could be made to the current iron condor. The important thing to do is look at the benefit the trade will provide to the existing trade compared to the risk that is added.

No trade adjustment is risk free. Generally, any time an adjustment is made in one direction, risk is added in the opposite direction.

As an added exercise, take a look at the existing trade and see if you can come up with additional adjustments. I'd love to hear your ideas. If I get some really good ones, I'll post them in next week's update. Submit them through the Contact Me page.

Update 4/20/2010

Last week, I closed the put spread for $.20 leaving me with just the call spread. I was hoping to get some good ideas to share in terms of ways to adjust this iron condor trade. I had listed some ideas last week of ways to adjust understanding that there were many possible techniques that could be employed.

Late last week I entered a call calendar spread as a separate trade with the idea that it could potentially help this position. This was a May/June4 $123 call. That's just beyond my long call strike. The idea is to protect against a stronger move that would blow through my call spread altogether.

This morning, I also sold 2 contracts of a $118/116 put spread for $.36 credit to form a skewed iron condor with a tighter range between the short strikes than the original iron condor. I only sold 2 contracts rather than 3 because there is still a risk of the SPY selling off more. I'll be watching this closely. The result is a risk graph on this trade that looks like the below image.

adjusted iron condor risk graph

Notice that there are two different levels of profit if the SPY runs up between $120 and $123. One is a result of staying below $120, which is the short strike of the call vertical spread. The other is a result of landing at the short strike of the call calendar..

I don't know whether we'll hit either one of these but it gives me more options in terms of the trade management to close or roll at opportune times.

Update 4/28/2010

There's been a bit of a sell-off over the last few days. That actually pushes us closer to the lower side of the range of profit. As of today's close,  we're sitting pretty close to the first profit peak near $120. It's not clear at all what the market will do with everything going on. It may be this is a short term pullback or it could turn into something bigger.

We still have the calendar spread on at $123 in case there is another round of buying. Depending on how long that takes, the calendar spread could widen out quite nicely. In addition the put vertical spread will do well. The only thing at risk is the remainder of the iron condor, which is the 122/120 call spread.

Right now, it's too expensive to close this spread and I've already sized it to sustain the maximum loss. It's not a good idea to change my rules at this point. The only thing to do is let the trade play out and allow more time to pass. We're still 4 weeks until expiration so there's plenty of time premium left in the options.

Update 5/13/2010

With the heavy selling, I'm now completely out of the original iron condor. I closed the call spread the other day for $.21. Now, if I'd have just left this trade alone, it would have been the perfect trade. But hindsight is 20/20.

What I have left in this trade is a small 2 contract put spread I put on as an adjustment several weeks ago when it looked like the market was a lot more bullish. This leaves me slightly bullish with a position that would benefit with the SPY above  $118. With this trade remaining, what is the risk in the trade?

I have a 2 contract put spread that is $2. That means my absolute risk is $400. However, I received a net $.66 on the original iron condor (1.07 - .20 - .21). That was on 3 contracts initially, which leaves my net credit $198. In addition, I received $.36 per contract on the put vertical. With two contracts, that's an additional $72 for a total of $270 in net credit at this point. As a result, my risk in the trade is only $130 assuming the SPY closes below $118 by expiration.

The problem is that this is that next week is expiration week. That means I'll likely be out of my positions in the early part of next week. That may not give enough time for the SPY to move unless it makes a large move in the next few days - a possibility that isn't impossible in the current volatile climate we're in.

Update 5/21/2010 (Closing Update)

This trade also closed with a small loss. It certainly could have been worse, but it also could have been better.

I put this trade on with 3 contracts and a $1.07 credit for a total credit of $321. I closed the put spread for $.20 or a total of $60. I sold a 2 contract put spread for $.36 or $72 total. I closed the call spread for $.21 debit or $63 total and finally closed the 2 contract put spread for $2 each or $400 total. That makes my total loss in this trade $321 - 60 + 72 - 63 - 400 or $130.

That's not too bad considering my initial max risk was about $279. On the other hand, if I'd have left this trade alone, it would have realized the target profit of 60% of the initial credit or $192.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

Note: This trade discussion is for educational purposes only. I am NOT making any recommendations on the trade or the underlying stock or ETF. If you decide to follow this trade, please do so in a paper trading account. Trading options involves risk and some options strategies can result in losing more than the original amount invested.

thinkorswim, Division of TD Ameritrade, Inc. and Success With Options are separate, unaffiliated companies and are not responsible for each other's services and products.

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